Paradox of thrift: Why a high savings rate is bad for the economy?

Let me ask you three questions.

Question 1: Do you have high savings?

Question 2: Do you save at the expense of putting off critical purchases?

Question 3: Do you think that is good for the economy?

Well if the answer to the questions is yes, yes and yes, then you might find this piece very interesting.

In the 1940’s John Maynard Keynes pulled the world attention to a theory that had been around since biblical times. The theory states that “The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy.”

The first reference to this theory came from the The Fable of the Bees: or, Private Vices, Publick Benefits (1714) by Bernard Mandeville, the title itself hinting at the paradox, and Keynes citing the passage:

As this prudent economy, which some people call Saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbors. This, I think, is an error.

 (Source: Wikipedia)

Now how is that possible one might wonder? But to Keynesian economists the answer is very simple. In an ideal scenario total income would be equal to total expenses and the savings would match the investments. So in other words total savings would equal investments.

This equation holds everything in balance with all other factors being normal.

Total Income: Total expenses= Total Investments: Total Savings

In other words If the savings is increased then the equilibrium shifts against investments at a lower value, which finally affects the total income leading to a weakening of the economy.

So that is the theoretical logic, let me try to explain with an example.

In the 70’s and 80’s Japan was at the forefront of world economy winning the war. From electronics to Automobiles the Japanese brands could do no wrong. Soon Japanese brands like Toyota and Sony were household names across the world. Japanese management practices were being copied and there were many best sellers on the rise of Japan. Hollywood also made some very funny anti-Japanese movies.

But then in 1990’s the Japanese juggernaut stalled. Sales and exports declined and Japanese economy went into recession, a recession that lasted almost a decade. The reason for the recession was that Japanese being very cautious on the economy curtailed spending. As the exports were falling, the Japanese consumers increased the saving rate, to brace themselves for the tight days ahead. This led to lesser spending in the local economy and further loss of business for the local Japanese establishments. So now not only the exporters were facing loss of sales but also the local businesses were losing business. This led to further recession something that lasted for more than a decade.

India faced a similar challenge during the peak of the 2008 recession. Luckily for us domestic demand picked up at the right time and bailed India out of the jaws of the recession.

Do is savings good? The answer is yes, but as excess of anything is bad, the same holds true for savings. It is best to view expenditure as investments and invest in local businesses as that would drive the economy and help sustain growth.